"The market always rises when the Sword of Damocles finally falls," Deepak Mohoni, doyen of the Indian community of technical analysts remarked when the news of the US Federal Reserve tapering came through. Mohoni called it absolutely right - at least in the short-term. The US equity markets rose on the news and ended the week at all-time highs. The Indian markets dipped on the first session as the news was absorbed and then equities rose on Friday.
The Fed has put $85 billion worth of easy money out into the market every month since September 2012, in what is called the quantitative easing 3 (QE3) program. Every month, the Fed has bought $40 billion worth of mortgage based securities and $45 billion worth of US government bonds. This releases money into the hands of the sellers (mostly financial institutions). From January, the Fed will buy $5 billion less of each type of paper, thus pushing out "only" $75 billion a month.
The easing at $75 billion a month could continue indefinitely. It will definitely continue until US employment numbers drop to what the Fed considers satisfactory and also other US indicators such as inflation are in the zones the Fed desires. Meanwhile, the Japanese have their own QE of $75 billion a month and the European Central Bank is also keeping interest rates low.
Much of the easy money coming out of the tapering went straight into financial assets. Most equity markets around the world have benefited from this. The US market reaction can be explained as partially a relief rally. The possibility of tapering has been on the table since mid-2013 and many traders were expecting a much bigger cut, amounting to $15-30 billion.
The rally in India and elsewhere in other markets is more difficult to explain. The chances are high that most of the "tapered $10 billion" will be cut out from emerging market (EM) allocations. The US-based FIIs will probably continue to buy stocks outside the US, but they will buy less.
This should have two long-term effects.
One effect is that there will be a tendency for equities to slide in EMs. The second is that there will be a hardening of the US dollar. The latter tendency will be reinforced by a likely rise in US bond yields. We've already seen the benchmark 10-year US bond rise since the taper was announced. If dollar yields increase, there will be a tendency to switch to those instruments in preference to more risky EM assets.
This could set off a trend of a hardening dollar. The US is a net importer. So, a high dollar makes goods and services cheaper in dollar terms. This means US inflation, already low, will drop further. However, since dollar interest rates are extremely low, it's unlikely that rates will fall further.
This should mean an eventual correction in EM equity values. We'll have an inkling of that in January, when most FIIs will be reviewing their allocation patterns anyway. However, factoring in the guarantees that the Fed will not taper again soon, there is also a sort of floor on EM equity values. Hence, there is a justification of sorts for the EM relief rally.
Stock market corrections and rallies are never smooth and they are always liable to overshoot in both directions. It may seem absurd but there is a chance that the current rally will push the market to higher highs. After all, traders were assuming larger cuts in all equity allocations would be forced upon them by the Fed.
There is also a chance that the correction, as and when it starts, will push the market down deeper than expected. Prices are already ruling high and if they travel even higher, they will need more and more fuel in the form of cash to maintain trajectory. There is a point at which the taper will bite and prices will start coming down.
Valuations are useless when it comes to benchmarks for such moves. These are generated purely by a combination of liquidity and sentiment. The next three or four weeks could see a see-saw in market prices and higher daily volatility as confused traders readjust. It may make sense to stay out. If you want to fish in troubled waters, be prepared for sudden reversals of direction.
The Fed has put $85 billion worth of easy money out into the market every month since September 2012, in what is called the quantitative easing 3 (QE3) program. Every month, the Fed has bought $40 billion worth of mortgage based securities and $45 billion worth of US government bonds. This releases money into the hands of the sellers (mostly financial institutions). From January, the Fed will buy $5 billion less of each type of paper, thus pushing out "only" $75 billion a month.
The easing at $75 billion a month could continue indefinitely. It will definitely continue until US employment numbers drop to what the Fed considers satisfactory and also other US indicators such as inflation are in the zones the Fed desires. Meanwhile, the Japanese have their own QE of $75 billion a month and the European Central Bank is also keeping interest rates low.
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US job number calculations are mildly complicated and the intricacies are not relevant. What is relevant is the market expectation that the numbers targeted by the Fed will not be hit in a hurry. Hence, further tapering is unlikely to occur for several months, maybe not even for another year.
Much of the easy money coming out of the tapering went straight into financial assets. Most equity markets around the world have benefited from this. The US market reaction can be explained as partially a relief rally. The possibility of tapering has been on the table since mid-2013 and many traders were expecting a much bigger cut, amounting to $15-30 billion.
The rally in India and elsewhere in other markets is more difficult to explain. The chances are high that most of the "tapered $10 billion" will be cut out from emerging market (EM) allocations. The US-based FIIs will probably continue to buy stocks outside the US, but they will buy less.
This should have two long-term effects.
One effect is that there will be a tendency for equities to slide in EMs. The second is that there will be a hardening of the US dollar. The latter tendency will be reinforced by a likely rise in US bond yields. We've already seen the benchmark 10-year US bond rise since the taper was announced. If dollar yields increase, there will be a tendency to switch to those instruments in preference to more risky EM assets.
This could set off a trend of a hardening dollar. The US is a net importer. So, a high dollar makes goods and services cheaper in dollar terms. This means US inflation, already low, will drop further. However, since dollar interest rates are extremely low, it's unlikely that rates will fall further.
This should mean an eventual correction in EM equity values. We'll have an inkling of that in January, when most FIIs will be reviewing their allocation patterns anyway. However, factoring in the guarantees that the Fed will not taper again soon, there is also a sort of floor on EM equity values. Hence, there is a justification of sorts for the EM relief rally.
Stock market corrections and rallies are never smooth and they are always liable to overshoot in both directions. It may seem absurd but there is a chance that the current rally will push the market to higher highs. After all, traders were assuming larger cuts in all equity allocations would be forced upon them by the Fed.
There is also a chance that the correction, as and when it starts, will push the market down deeper than expected. Prices are already ruling high and if they travel even higher, they will need more and more fuel in the form of cash to maintain trajectory. There is a point at which the taper will bite and prices will start coming down.
Valuations are useless when it comes to benchmarks for such moves. These are generated purely by a combination of liquidity and sentiment. The next three or four weeks could see a see-saw in market prices and higher daily volatility as confused traders readjust. It may make sense to stay out. If you want to fish in troubled waters, be prepared for sudden reversals of direction.